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Human & Financial Capital

I was involved in a very interesting discussion with a client in the past week regarding the future value of assets and the role this plays your existing investment portfolio. Most advisers would (or at least should) take great care in estimating the future value of an investment portfolio in order to plan for a client’s retirement. There are an innumerable number of calculation methods and tools available to assist clients in this very important part of their lives.

It is a well-known fact that any shortfalls in the current level of your assets need to be covered with an insurance policy. The capital shortfall to cover your dependants is made up with a life insurance policy while your future earnings can be insured with an income protection policy. There are definitely many more uses for broader life insurance products but for the topic of discussion the above will suffice. With the above 2 products we insure very real assets, albeit assets we would only realise in the future.

What this means is that most individuals have a very constant total level of wealth throughout their lifetime, your total capital. Your total capital is made up by your Financial capital (the assets already accumulated) and Human capital (the assets that you will still earn/procure over the course of your life). The 2 pools of capital are interlinked and both should be regarded with equal diligence.

Below is a graphic illustration of how the real levels of Human and Financial capital change over time:

Note the Total capital remains unchanged throughout the measured time period, as it is the sum of Human and Financial capital.

The most daring assumption in the above graph, and consequently the topic of discussion, is the fact that contributions are made and increased consistently and without interruptions. This may be a realistic assumption for someone employed with the same company throughout their career following a linear path to the top. For such an investor, the Human capital is very predictable and stable, it is also fully absorbed into Financial capital. Although not a realistic assumption it is nigh impossible to account for potential future losses in your Human capital portfolio.

The more predictable your Human capital over time the more risk you can allow in your Financial capital. If your Human capital is volatile, think of an entrepreneur or an individual remunerated largely with performance bonuses, you cannot quite allow for the same measure of risk in the Financial portfolio. These individuals face a risk that the Human capital is not fully absorbed into Financial capital. The converse is also true that they might end up with more Financial capital than estimated.

Incorporating the profile of your Human capital into longer term planning goes a long way in helping investors reach their goals. If the value of your Human capital is not predictable over time you may be required to delve into your Financial capital at some stage. This means that not all of your assets can be invested into a growth oriented strategy, regardless of your age or willingness to assume risk, as an untimely redemption out of a growth strategy can lead an investor to sustain losses.

I concluded the discussion with the statement that an investment portfolio can contain a certain amount of risk in both your Financial and Human capital. The riskier your Human capital the less risk you can take up in your Financial capital and vice versa.

We, at Seed, take great care to be cognisant of the various factors important in effectively managing our clients’ assets. We also understand that each client has unique circumstances that requires thorough and diligent consideration.

Seed Weekly - The Seed Equity Fund

This week I will be focusing on our youngest fund in our range namely the Seed Equity fund. This is a low cost equity fund managed by Seed, under advice from Prof Paul van Rensburg of Salient Quants. The fund aims to provide investors with returns in excess of the JSE ALSI Total Return (J203T)

Our current fund range is depicted below:

Investment Styles

The major equity investment styles can be broken down into Active versus Passive Management, Value versus Growth, and Large Cap versus Small Cap.

Active versus Passive: Actively managed funds typically have portfolio managers constantly seeking superior returns with for example expert research analysts and big support teams. Trading in the funds can happen on an ongoing basis and investors usually pay more for these funds compared to passively managed funds. On the other hand empirical research shows that over the long run, many passively managed funds generate better returns for their investors compared to similar actively managed funds – with the added bonus of the much lower cost.

Value versus Growth (Momentum): The value investment style is focused on buying the best quality companies for the lowest price possible. Companies in favour would be companies with low price to earnings ratios, high dividend yields and low price to sales ratios. A momentum style would be investing in companies which are growing quickly and typically reinvesting most or all of their earnings to fuel continued growth. These companies typically have lower dividend yields with high earnings growth and high profit margins.

Large Cap versus Small Cap: This is purely a measurement of the size of the company as calculated by its market capitalization. Small Caps generally have greater earnings potential but typically also more risk.

Where does Seed Equity fit in?

According to international research by BCA (The Bank Credit Analyst) if one is looking for solid consistent returns then style diversification is important. The Seed Equity fund makes use of “Smart Alpha” techniques and remains style neutral between value and momentum.

Because the fund has a systematic investment process, we have accurate data since January 2003 and actual portfolio data since 2009. The results below reflect the comparison of the fund’s maximum underperformance and the number of months it spent in drawdown versus a range of well-known funds with a similar history.

All of the funds in this study have outperformed the ALSI since this inception date, but many investors have had to sustain a significant period of underperformance – in some cases up to 10 years.

Ideally a fund also aims to outperform the market on a consistent basis. This is especially important for unit trusts because investors are investing at various stages and therefore each has their own return experience.

From the table above it is evident that the Value and Momentum building blocks individually go through periods of underperformance that are just as long as some of the other active managers. However when blended together the Seed Equity fund has a materially shorter period of ‘longest period of underperformance’ because of the fund’s style diversification.

Performance

In a similar way, the graphs below reflect the separate building blocks and then a composite of a 50/50 blend.

When combined at equal weights it is clear to see on the graph below, that the return profile is smoothed out and in fact the combined styles have achieved a higher cumulative outperformance.

Compared to its peers the fund is relatively young but the two separate strategies do have an actual 5 year track record. The fund has a two year track record and the end of April 2015 the fund returned 19.5% for the 1 year and was ranked 34 out of 132 funds in its category.

In the coming weeks when we will introduce you to our other two funds namely the Seed Absolute and Seed Flexible Funds.

Seed Weekly - Perspective

Last week I had the privilege of spending 9 days surrounded by positive people riding through the most beautiful places and being helped after the ride by hordes of children with impeccable manners. This wasn’t in some exotic foreign location; I had the privilege to “ride the beloved country”. The hospitality, friendliness, and just the overall positive ambiance was an honour to experience.

As South Africans we tend to call ourselves realists i.e. we always focus on the negative. The huge number of foreigners on the ride kept on reminding us how incredibly lucky we were to be able to live in South Africa. I immediately hear a number of people asking what my experiences last week have to do with a financial advice article and it is quite simple really. One of my tasks as a financial advisor is to help investors with the asset and geographic allocation of their investments. I remember back in 1997 when Chris Ball, the chairman of the 2004 Cape Town Olympic Bid, said that in their projections they were using an exchange rate of R20/$ for their 2004 cost projections, I also remember in 2000 as a financial advisor having most of my clients telling me that South Africa was a basket case, Mandela is sick, the Rand is rubbish and they want to take all their money offshore. If we look at the graph below you can see that for a while the offshore investments outperformed local investments but this success was short lived. Both the South African market and the Rand did incredibly well with the Rand only now reaching the highs/lows (depending on your perspective) of December 2001, but the local asset markets delivering materially more returns (note the log scale used).

I am in no way proposing that you should have no investments offshore and I am also the first one to admit that as a nation we have an incredible knack of scoring “own goals” where Eskom, corruption, government incompetence, Xenophobia, shocking education, and unproductive labour are just a few of the more prominent own goals. What we fail to remember is that very often our currency has very little to do with internal events, be they good or bad. The chart below shows the incredibly high correlation between the ZARUSD and the BRLUSD. One US dollar cost R4.50 in January 1997 and is now hovering around R12, one US dollar cost around BRL1 in January 1997 and is now hovering around BRL3.

Geographic diversification is vital to reducing the risk of any portfolio, so it is important as a South African to have money invested globally. My big concern, however, is that at the moment a number of people appear to be “throwing the baby out with the bath water” in their rush to get all their assets offshore. This reminds me of the period we went through in 2000 and 2001. Investors tend to forget that if they plan on retiring in South Africa, the majority of their investments need to be domiciled in rands. They also tend to forget Ian’s article of a few weeks ago that shows that the local stock market actually benefits from the weaker rand due to the internationalisation of our index.

So, when you look at your investment portfolio, it is imperative to take a step back to get a fresh perspective on the bigger picture.

Seed Weekly - Clicks Group Ltd

The Clicks Group Ltd is a healthcare retail and supply group, listed on the JSE in the Food and Drug Retailers sector. The Clicks retail stores are known and loved by SA’s consumers and the Group enjoys around 18% of the retail pharmacy market share.

History

The first Clicks store was opened in Cape Town in 1968, with a listing on the JSE following in 1979 at a market capitalisation of R 10m. Legislation at the time prevented corporate ownership of pharmacies, so Clicks operated as a drugstore without drugs, selling only off-the-shelf medication.

By 1983 the group operated 44 stores, with turnover exceeding R 100m, and these numbers increased to 155 and R 500m by 1991. In 1992 Clicks acquired Musica, SA’s leading retail music brand at the time and launched the successful ClubCard loyalty programme in 1995.

In 1998 the Group expanded to Australia, purchasing the Priceline chain of stores and also acquiring House and Price Attack in the next few years. By 2003 the group had 191 franchise stores in Australia, but the whole of New Clicks Australia was sold to a consortium of private equity investors in 2004.

Legislation was passed in 2003 that enabled Clicks to finally open dispensaries inside existing Clicks stores, which the Group has done very successfully over the next 12 years.

Operations

The Group’s brands include the well-loved Clicks retail stores and pharmacies, The Body Shop and Musica. The Group also operates United Pharmaceutical Distributors (UPD), a wholesale distribution company supplying to Clicks pharmacies, hospitals and independent pharmacies.

The Group’s retail brands have a combined footprint of 632 stores, including 26 in Namibia, Botswana, Swaziland, and Lesotho. The Group has set a longer term target of 600 Clicks stores in SA alone, and aims to open 24 new stores and 20 new pharmacies in this financial year.

Latest Financial Results

Clicks recently released its interim results for the six months ended 28 February 2015. Group turnover increased by 14.1% to R10.7bn, with Clicks turnover up 10.5% and UPD turnover up 20.7%.

Operating margin remained stable compared to the previous period at 6.0%, with the margin for retail operations at 7.3% far exceeding the margin of 2.3% on distribution operations. Retail operations accounted for 83% of Group profits.

Diluted HEPS increased by 12.8% to 177.6 cents, while management also increased the interim dividend by 22.4% to 65.5 cents per share.

Retail operating expenses increased by 11.5% due to increased investment in stores, staff and advertising costs. Sales growth of 10.5% in Clicks stores was driven by innovative, value-driven promotions, with promotions comprising 29% of total sales.

The Body Shop managed to increase turnover by 12.2%, and has expanded to 47 standalone stores as well as outlets in 92 Clicks stores. Musica managed to increase sales by 2.4%, and increased market share in all product categories due to competitors closing down.

Turnover in the UPD distribution business increased by 20.7%, driven by volume growth of 24.3% and growth of 56.1% in turnover from channels other than Clicks, hospitals and independent pharmacies. UPD managed to increase its wholesale market share from 25.4% to 26.2%.

Outlook and Fundamentals

Clicks’ management acknowledges that the South African consumer remains under pressure, and this is expected to remain unchanged through the second half of the financial year. The Group’s value proposition and re-launched ClubCard incentive is expected to ensure continued growth. A record amount of R 379m is allocated for capital expenditure for this financial year.

At a PE of 24 and DY of 2.3%, Clicks does not look particularly attractive compared to the JSE’s numbers of 19.2 and 2.8% respectively. However, the share price is starting to show some strong momentum, with a 48% return over the past 12 months.

Clicks is not included in the Value or Momentum building blocks comprising the Seed Equity Fund at the moment, but if strong price and earnings momentum continues it may be included in the Momentum building block portfolio.